Daily State Of The Markets: The Next Decline Will Tell Us...

Includes: DIA, IWM, QQQ, SPY
by: David Moenning

Even the most ardent bulls will have to admit that the current joyride to the upside might be getting a little out of hand. For example, the S&P 500 has finished higher 13 of the last 16 days and 11 of the last 13. And since David Tepper made his comments about not being "too frickin long" here, the S&P 500 has gained +4.2 percent and broken out to new all-time highs on 9 separate occasions.

In short, the blast higher has been impressive and has caught a great many investors leaning the wrong direction. The chart below kinda says it all here as there is no denying that the bulls are once again large and in charge.

S&P 500 - Daily

So, what do the fast-money traders do when they are on the wrong side of a runaway train? Short the SPDR S&P 500 Trust (SPY), of course!

Shorts Loading Up - Again

Traders who tend to see the glass as at least half-empty have had a rough go of it over ever since all the talk of the "fiscal cliff" back in 2012. And yet, according to Bloomberg, our furry friends in the bear camp remain steadfast in their view that stocks MUST fall - and soon.

Bloomberg reported Monday that shorts on the SPY have reached nearly 11 percent of the shares outstanding, which is the highest proportion of short sales to shares outstanding since 2012. Oh, and bets against the XLK (Technology Select SPDR) are now 67 percent above the average seen over the last 12 months.

One can surmise then that the bears are reloading their short positions in response to the S&P 500 marching higher into new-high territory. The thinking is that with the market now extended and overbought, it is time for a pullback - and EVERYBODY knows it.

So What Comes Next?

History shows that one of two things is about to happen in the near term. Either the much anticipated pullback becomes a self-fulfilling prophecy where the sellers have their way with the indices for a few days - or - the bulls continue to romp, the shorts capitulate, and the market spikes even higher.

Experience teaches us that option number one might be preferred as most "blow off" phases don't end well.

At this stage, any decline lasting more than a couple hours would likely be welcomed by a great many market players. You see, how the market reacts during a pullback, a consolidation, a correction, or a "sloppy phase" can tell you a lot about what comes next. So, here's hoping that we get any of the above sooner rather than later.

The Way the Market Declines Will Indicate...

It may sound strange for someone who is admittedly long the market to be hoping for the bears to get back in the game. But here's the thing. The way the market acts during the next decline will tell us a lot about how much gas the bulls have left in the tank and whether or not the current leg higher has staying power.

So here's what we've got. Stocks are at all-time highs and the shorts are pressing their bets that the market will soon decline. Should the S&P pull back a couple percent or so without any really scary news, the shorts will likely take whatever gain they might be able to eek out on the trade and feel good about it. The bulls would then "buy the freaking dip" and the market could continue to stair-step higher.

In other words, a shallow decline without a lot of conviction on the downside would be a signal to the bulls that it's time to BTFD again.

However, if the bears can come up with a raison d'être and create a nasty spill in the indices, the game could easily play out differently.

If there is a decent catalyst and some participation on the downside, then the sellers may be able to convince the buyers that it would be best to "stand aside" for a while. After all, up until three weeks ago, 2014 had been the year of the "breakout fakeout." So, if there is any indication that a new crisis is emerging, the buyers might become very shy about putting capital to work in a market that is extended on many levels.

So, which will it be? Will we see a mild pullback which inspires the bulls to buy the dip or something more grizzly in nature that scares the heck out of everyone? Or... will the bulls just keep on keepin' on, forcing all of those shorts to cover in an explosive upside surprise?

Stick around, this is probably going to be interesting.

Turning to This Morning...

Overnight, China's stock market improved smartly in response to the PBOC's decision to cut the reserve requirement for some banks. However, across the pond, the markets are fractionally mixed. The economic calendar is light today after the NFIB reported this morning that its Small Business Optimism Index hit the highest level since September 2007. Finally, it looks like the bears will get a chance to step up to the plate this morning as U.S. stock futures are currently pointing to a lower open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:

- Japan: -0.85%

- Hong Kong: +0.86%

- Shanghai: +1.11%

- London: -0.41%

- Germany: +0.13%

- France: +0.02%

- Italy: +0.04%

- Spain: -0.19%

Crude Oil Futures: +$0.29 to $104.70

Gold: +$1.60 at $1255.50

Dollar: higher against the yen and euro, and pound.

10-Year Bond Yield: Currently trading at 2.639%

Stock Futures Ahead of Open in U.S. (relative to fair value):

- S&P 500: -3.92

- Dow Jones Industrial Average: -22

- NASDAQ Composite: -7.54

Thought For The Day... "You miss 100% of the shots you don't take" -- Wayne Gretsky

Positions in stocks mentioned: None.

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